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Equity Strategy by Hunter Bronson

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Equity Strategy by Hunter Bronson Quarterly Economic Update June 9, 2020 MACROECONOMIC COMMENTARY Page 2 Fiscal/Monetary Policy By Michael McNair The speed and magnitude of the government response to the pandemic has been unprecedented. Congress has enacted a cumulative $1.6 trillion of tax cuts and spending that will hit the economy by September 30th. The total fiscal stimulus is equal to 7.9% of Pre-COVID GDP. The litany of provisions within the CARES Act legislation can be overwhelming; however, we can provide a clearer view of the legislation’s intentions by categorizing the measures into three groups: emergency health care response, safety net, and economic stimulus. Emergency Response Congress earmarked $8.3 billion to combat COVID-19 and increase our health care infrastructure to cope with an influx of patients. The money is being used to increase hospital capacity as well as helping to fund the development of vaccines, therapeutics, and diagnostics. Safety Net The CARES Act included a refundable tax credit for two weeks of paid sick leave, 10 weeks of paid family medical leave, emergency grants for unemployment insurance, and nutrition assistance waivers. Economic Stimulus Stimulus to individuals included an increase in unemployment benefits and provided $293 billion of direct payments to households, with a maximum of $1,200 per individual ($2,400 for joint filers) and $500 per child under the age of 17. The CARES Act also provided a number of provisions for businesses including: The Paycheck Protection Plan provided businesses with less than 500 employees the funds to maintain payroll, rent, and utilities. $450 billion for company loans and loan guarantees. Direct aid for negatively impacted industries, including $150 billion for hospitals and $150 billion for state governments. A fourth stimulus bill included an additional $484 billion of aid for small businesses and hospitals to bolster the previously enacted programs. Page 3 Monetary Policy The unprecedented fiscal policy response enacted by congress was matched by the monetary response by the Fed. The Fed quickly stepped into its role of lender of last resort and stabilized financial markets reeling from COVID induced lockdowns. On March 16th, the Fed cut rates to 0.25% and instituted an open-ended $700 billion quantitative easing (QE) program. In addition to QE and interest rate cuts, the Fed enacted nine separate domestic credit and loan facilities, some of which break new ground in terms of Fed participation in markets. To get a better grasp of the programs and their intentions we break the programs into three groups: classic lender of last resort, fiscal partner, and direct investor of last resort. Classic Lender of Last Resort Businesses and individuals need to keep a portion of their savings in cash for spending and safety purposes. Un-invested cash does not earn a return but liquidity needs prevent this cash from being invested in anything except the shortest of maturities. However, borrowers typically want to borrow cash to be paid back over long-time periods. The role of the banking system is to rectify the mismatch between the short- term liquidity needs of savers with the long-term, risky funding needs of borrowers. Through the process of credit intermediation, the banking system transforms risky, long- term loans into seemingly credit-risk free, short-term, money-like instruments that can be withdrawn on demand. However, the stability of the banking system is dependent on its continued access to short-term funding. If savers ever get worried and stop lending their cash into the system, banks can be forced to fire sell assets. Over the last several decades a shadow banking system has developed which now exceeds the traditional banking system in terms of the volume of credit intermediation. Both the traditional and shadow banking systems consist of borrowers and savers. However, non-bank financial institutions (i.e. shadow banks) replace traditional banks as financial intermediaries in the shadow banking system. The classic asset-liability mismatch is inherent to both shadow and traditional banks; however, traditional banks have FDIC deposit guarantees and access to the Fed to prevent a bank run. Lack of access to central bank liquidity or public sector guarantees has forced the shadow banking system to rely on securities financing transactions to ensure the safety of saver’s cash with high-quality securities as collateral. In March the market participants in the shadow banking system began to question the quality of the collateral securing their funds. The stress in the shadow banking system was reminiscent of 2008. However, the Fed was quick to respond – unlike 2008. Page 4 Walter Bagehot said, “central banks should lend freely to solvent firms against good collateral at a penalty rate.” On March 17 the Fed stepped into its role as lender of last resort and provided financial market participants in the shadow banking system with short-term funding in return for solid collateral. Though instead of requiring a penalty rate, as suggested by Bagehot, the rate was quite friendly. The Fed enacted three programs that fall into the classic lender of last resort basket: the Money Market Mutual Fund Liquidity Facility, the Primary Dealer Credit Facility, and the Term Asset-Backed Securities Loan Facility. Prime dealers and Money Market Mutual Funds are a vital part of the shadow banking system and the facilities allowed these participants to continue to provide short-term funding to businesses, while the Term Asset-Backed Securities Loan Facility allowed the Fed to step into the role of a shadow bank and provide short-term funding directly to institutions in return for collateral. These three facilities have been highly successful in stabilizing the shadow banking system and money market spreads are no longer stressed. Fiscal Partner Within the CARES Act, Congress allocated $454 billion for the Treasury Department that is to be levered 3 to 4 times by the Fed – providing at least $1.5 trillion to be distributed to whatever area of the economy the authorities determine it is needed. There are three facilities in the fiscal support basket. Two of these facilities make up the Main Street lending program, which will buy $600 billion of loans from banks. Banks can use these facilities to originate new loans to businesses. The issuing banks must retain 5% of the loan on their balance sheet with the Fed purchasing the remaining 95%. The Paycheck Protection Program Liquidity Facility is designed to facilitate the $349 billion Small Business Administration PPP lending by serving as a backstop buyer of the loans from the originating banks. Direct Investor of Last Resort In the programs mentioned above the Fed performed the traditional role of providing funding to financial market participants who are then able to perform their objective of providing funding to households and businesses. In contrast, the programs in this basket allow the Fed to provide funding directly to borrowers without the use of collateral. The Fed is breaking new ground with these policies and in some cases directly side-stepping the Fed charter which explicitly forbids such actions. The Fed’s Municipal Liquidity Facility will buy $500 billion in short-term debt issued by large municipalities. The Fed will lend directly to the state and local governments rather than buying municipal debt on the secondary market. Page 5 The Fed’s Commercial Paper Funding Facility will buy high-quality commercial paper, including asset-backed commercial paper (ABCP). Commercial paper is a short-term, non-collateralized debt instrument used by many companies for their short-term funding needs, or in the case of ABCP, it is used to fund household loans such as credit cards, mortgages, and student loans. The Fed’s Primary Market Corporate Credit Facility will buy debt directly from companies and the Secondary Market Corporate Credit Facility will buy corporate bonds from the secondary market, including the purchase of some high yield exchange-traded funds (ETFs). While the Commercial Paper Funding Facility provided funding directly to high-quality borrowers, the Secondary Market Corporate Credit Facility includes the purchase of debt from low-quality issuers and without the use of collateral. This is uncharted territory for the Fed to say the least. The purpose of the Fed’s credit and loan programs in not to prevent bankruptcies for insolvent borrowers. The Fed’s goal is to ring fence the insolvencies so they do not create a cascade that disrupts the credit markets and increases the cost of borrowing for the parts of the economy that are solvent. The fall in AAA and BBB spreads since the middle of March tell us the Fed’s efforts are working. Importantly, the market is differentiating between credit qualities despite fears that the Fed’s actions are distorting credit market pricing. High yield and high yield energy spreads remain stressed, as warranted by fundamentals, at over 600 and 1000 basis points, respectively. Page 6 The announcement of these various programs have helped the credit markets recover, but these programs have been slow to start up. The Fed programs add up to over $3 trillion but as of May, the Fed’s total credit purchases and loans was only $113 billion. Treasury Department Impacting Monetary Policy In August of 2015, the Treasury Borrowing Advisory Committee set new guidelines for the Treasury General Account (TGA), held at the New York Federal Reserve. The committee determined that under normal conditions the Treasury department should increase their cash deposits to at least $350 billion to be drawn down under special circumstances. The unintended consequence of the new guidelines is that changes the in the TGA balance have an outsized effect on financial conditions. When the Treasury is building their cash balance at TGA it drains reserves (i.e.
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